How to Avoid Paying Tax on Your Pension

How to Avoid Paying Tax on Your Pension

While it is difficult to avoid tax entirely on your pension income, there are several legitimate ways to minimise how much you pay. With careful planning, you can use allowances and flexible withdrawals to keep more of your pension savings and avoid pushing yourself into higher tax bands.

This article explains how pension income is taxed in the UK and the steps you can take to reduce or avoid paying tax where possible.

Understand how pensions are taxed

In the UK, most pension income is treated as taxable income, just like wages. This includes:

• Private pensions

• Workplace pensions

• Annuities

• The State Pension (though it is not taxed at source)

However, the first 25 percent of your defined contribution pension can usually be taken tax free. The remaining 75 percent is added to your total income and taxed at your applicable income tax rate.

Use your personal allowance

Every UK taxpayer has a personal allowance, which is the amount of income you can receive each tax year before paying any income tax.

• For the 2024 to 2025 tax year, the personal allowance is £12,570

If your total income in retirement, including pensions and any other earnings, is less than this amount, you will not pay any income tax.

Tip:

If your pension is your only income and you keep it below £12,570 a year, you will avoid paying income tax altogether.

Withdraw your pension in stages

Rather than taking a large lump sum, you can spread your pension withdrawals over several years. This approach, often used with drawdown pensions, helps keep your annual income within the lower tax band.

Example:

You could take just enough each year to stay within your personal allowance or the basic rate tax band, avoiding the higher rate of 40 percent.

This is especially useful if you have other savings or income sources and want to avoid pushing your total income too high in a single year.

Use the 25 percent tax free allowance wisely

You are usually entitled to take 25 percent of your pension pot tax free. You can:

• Take the full 25 percent upfront

• Take it in smaller chunks alongside taxable withdrawals

Spreading the tax free element across multiple years can help reduce the tax you pay by ensuring less of your withdrawals are taxed.

Use ISA income instead

Income from Individual Savings Accounts (ISAs) is completely tax free and does not affect your personal allowance. If you have money in an ISA, you can use it to supplement your income without increasing your tax liability.

This strategy works well alongside pension withdrawals, especially if you want to delay accessing your pension for longer or smooth out your income in retirement.

Consider deferring the State Pension

If you do not need the State Pension as soon as you reach State Pension age, you can choose to defer it. In return, you will receive a higher pension when you eventually claim it.

This can help reduce your taxable income in the early years of retirement and avoid overlapping with other income sources.

Use the Marriage Allowance

If you are married or in a civil partnership and one of you earns less than the personal allowance, you may be able to transfer a portion of the unused allowance to the other partner. This can reduce the tax paid by the higher earner by up to £252 per year.

Avoid triggering the Money Purchase Annual Allowance (MPAA)

If you take taxable income from your defined contribution pension, the amount you can pay into pensions in future with tax relief is usually reduced to £10,000 per year.

To avoid this restriction:

• Only take the 25 percent tax free lump sum

• Avoid accessing taxable pension income unless necessary

This allows you to continue making full pension contributions with the standard £60,000 annual allowance.

Make use of the Savings and Dividend Allowances

In addition to your personal allowance, you may also benefit from:

• Savings allowance – Up to £1,000 of interest tax free for basic rate taxpayers

• Dividend allowance – Up to £500 of dividend income tax free

These allowances can help reduce your overall tax bill if you have other investments alongside your pension.

Seek professional advice

Tax planning in retirement can be complex. A regulated financial adviser can help you:

• Plan withdrawals in a tax efficient way

• Make use of all your allowances

• Structure your income to avoid unnecessary tax charges

You can also use Pension Wise, a free government service, if you are aged 50 or over and have a defined contribution pension.

Final thoughts

While you may not be able to avoid tax on all your pension income, there are many ways to reduce how much you pay. Making use of your personal allowance, planning withdrawals carefully, and combining income from other tax free sources can make your pension go further.

Good planning can help you keep more of your money and enjoy a more comfortable retirement.